The Dhandho Investor by Mohnish Pabrai

My Thoughts

This book was recommended to me by Andrew Wilkinson. Well, not personally, I heard him mention it on one of the podcasts where he was a guest. Probably the My First Million podcast.

Since Andrew is one of my heroes I thought that I have to read it. And I was not disappointed, I loved it. Mohnish Pabrai did an excelent job here!

If you know who Warren Buffett, Charlie Munger and Andrew Wilkinson are and like their approach to business, you will love this book. The whole book can be summarized in the following sentence: “Heads, I win; tails, I don’t lose much!“.

It’s all about making investment bets with basic principles in mind that will help you minimize risk and maximize return. When I say investments, it could mean either acquiring whole businesses like Patels’ purchase of motels or just plain stock investments.

Summary

• You can use creative thinking to go around the problem of lack of capital. Richard Branson is an amazing example of this, creating a whole airline withouth butloads of cash.

• The Dhandho framework consists of nine key principles:

  • Focus on buying existing businesses
  • Invest in simple businesses in industries with slow change
  • Buy distressed businesses in distressed industries
  • Look for businesses with durable competitive advantages (moats)
  • Make few, big, and infrequent bets
  • Focus on arbitrage opportunities
  • Buy businesses at big discounts to intrinsic value
  • Seek low-risk, high-uncertainty businesses
  • Invest in copycats rather than innovators

• When invesing, simplicity is they key. If you can write down the business thesis in a one short paragraph it is a good sign. If, on the other hand, you need to fire up Excel for some financial modelling, that’s a red flag.

• Here are some ways to find distressed businesses:

  • If you read the business headlines on a daily basis, you’ll find plenty of stories about publicly traded businesses. Many of these news clips reflect negative news about a certain business or industry.
  • Stocks that have lost the most value in the preceding 13 weeks
  • Take a look at Value Investors Club (VIC; www.valueinvestorsclub.com).
  • Portfolio Reports (www.portfolioreports.com) is a monthly publication that lists the 10 most recent stock purchases by 80 of the top value managers
  • free alternative is looking directly at the public filings (e.g., SEC Form 13-F)
  • read The Little Book That Beats the Market by Joel Greenblatt. After reading the book, visit www.magicformulainvesting.com.

• To be a good capital allocator, you have to think probabilistically. Bet big when the odds are in your favor.

Highlights

Chapter 1 Patel Motel Dhandho

Dhandho (pronounced dhun-doe) is a Gujarati word. Dhan comes from the Sanskrit root word Dhana meaning wealth. Dhan-dho, literally translated, means “endeavors that create wealth.” The street translation of Dhandho is simply “business.” What is business if not an endeavor to create wealth?

Dhandho is all about the minimization of risk while maximizing the reward. The stereotypical Patel naturally approaches all business endeavors with this deeply ingrained riskless Dhandho framework—for him it’s like breathing. Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.

Chapter 3 Virgin Dhandho

My take on Virgin Atlantic is simply this: if you can start a business that requires a $200 million 747 jumbo jet and a boatload of employees in a tightly regulated industry for virtually no capital, then virtually any business that you want to start can be gotten off the ground with minimal capital. All you need to do is replace capital with creative thinking and solutions.

The Virgin Atlantic business model is pure Dhandho. Heads, I win; tails, I don’t lose much! The Virgin Group today is a privately held group of 200 + businesses with about $7 billion in annual revenue. It generates about $600 to $700 million a year in free cash flow. The common ingredient in virtually all 200 + businesses is that there was very little money invested in any of them at startup. Heads, I win; tails, I don’t lose much!

Again, Virgin had virtually no investment. The entire backend was handled by the bank. All Virgin provided was the brand and helped with the marketing—very little cash invested. In return, it got a good chunk of the profits. Heads, I win; tails, I don’t lose much!

Chapter 4 Mittal Dhandho

The same story was repeated with the Sidek Steel plant in Romania, and the Mexican government handed him the keys to the Sibalsa Mill for $220 million in 1992. It had cost the Mexicans over $2 billion to build the plant. Getting dollar bills at 10 cents—or less—is Dhandho on steroids. Mittal’s approach has always been to get a dollar’s worth of assets for far less than a dollar. And then he has applied his secret sauce of getting these monolith mills to run extremely efficiently.

Chapter 5 The Dhandho Framework

• 1. FOCUS ON BUYING AN EXISTING BUSINESS.
• 2. BUY SIMPLE BUSINESSES IN INDUSTRIES WITH AN ULTRA-SLOW RATE OF CHANGE.

We see change as the enemy of investments … so we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.1 —Warren Buffett

• 3. BUY DISTRESSED BUSINESSES IN DISTRESSED INDUSTRIES.

I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.4 —Warren Buffett

the very best time to buy a business is when its near-term future prospects are murky and the business is hated and unloved. In such circumstances, the odds are high that an investor can pick up assets at steep discounts to their underlying value.

• 4. BUY BUSINESSES WITH A DURABLE COMPETITIVE ADVANTAGE—THE MOAT.
• 5. BET HEAVILY WHEN THE ODDS ARE OVERWHELMINGLY IN YOUR FAVOR.
• 6. FOCUS ON ARBITRAGE.
• 7. BUY BUSINESSES AT BIG DISCOUNTS TO THEIR UNDERLYING INTRINSIC VALUE.
• 8. LOOK FOR LOW-RISK, HIGH-UNCERTAINTY BUSINESSES.

Low risk and high uncertainty is a wonderful combination. It leads to severely depressed prices for businesses—especially in the pari-mutuel system-based stock market. Dhandho entrepreneurs first focus on minimizing downside risk. Low-risk situations, by definition, have low downsides. The high uncertainty can be dealt with by conservatively handicapping the range of possible outcomes. You end with the classic Dhandho tagline: Heads, I win; tails, I don’t lose much!

• 9. IT’S BETTER TO BE A COPYCAT THAN AN INNOVATOR.

And that’s the Dhandho framework. To summarize: • Invest in existing businesses. • Invest in simple businesses. • Invest in distressed businesses in distressed industries. • Invest in businesses with durable moats. • Few bets, big bets, and infrequent bets. • Fixate on arbitrage. • Margin of safety—always. • Invest in low-risk, high-uncertainty businesses. • Invest in the copycats rather than the innovators.

Chapter 6 Dhandho 101: Invest in Existing Businesses

When humans buy or sell whole businesses, both sides have a good sense of what the asset is worth and a rational price is usually arrived at. Sometimes in these transactions, if the business or industry is distressed, buyers might get a bargain like Papa Patel did, but those are anomalies. Sellers usually get to time these sales to their benefit. As a result, you typically end up with fair to exuberant pricing.

Chapter 7 Dhandho 102: Invest in Simple Businesses

Simplicity is a very powerful construct. Henry Thoreau recognized this when he said, “Our life is frittered away by detail … simplify, simplify.” Einstein also recognized the power of simplicity, and it was the key to his breakthroughs in physics. He noted that the five ascending levels of intellect were, “Smart, Intelligent, Brilliant, Genius, Simple.” For Einstein, simplicity was simply the highest level of intellect. Everything about Warren Buffett’s investment style is simple. It is the thinkers like Einstein and Buffett, who fixate on simplicity, who triumph. The genius behind E=mc2 is its simplicity and elegance. Everything about Dhandho is simple, and therein lies its power. As we see in Chapter 15, the psychological warfare with our brains really gets heated after we buy a stock. The most potent weapon in your arsenal to fight these powerful forces is to buy painfully simple businesses with painfully simple theses for why you’re likely to make a great deal of money and unlikely to lose much. I always write the thesis down. If it takes more than a short paragraph, there is a fundamental problem. If it requires me to fire up Excel, it is a big red flag that strongly suggests that I ought to take a pass.

Chapter 8 Dhandho 201: Invest in Distressed Businesses in Distressed Industries

How do we get a list of distressed businesses or industries? There are many sources, but here are six to begin with: 1. If you read the business headlines on a daily basis, you’ll find plenty of stories about publicly traded businesses. Many of these news clips reflect negative news about a certain business or industry. … 5. Take a look at Value Investors Club (VIC; www.valueinvestorsclub.com). … downward from there. 6. Last, but certainly not least, please read The Little Book That Beats the Market by Joel Greenblatt. After reading the book, visit www.magicformulainvesting.com.

2. Value Line publishes a weekly summary of the stocks that have lost the most value in the preceding 13 weeks. It is another terrific indicator of distress. This list of 40 stocks routinely shows price drops of 20 percent to 70 percent over that period. The ones with the largest drops are likely the most distressed. It also has a summary every week of the stocks with the lowest price-to-earnings ratios (P/Es), widest discount to book value, highest dividend yield, and so on. Not all these businesses are distressed, but if a business is trading at a P/E of 3, it is worth a closer look. 3. There is a publication called Portfolio Reports (www.portfolioreports.com) that is published monthly. It lists the 10 most recent stock purchases by 80 of the top value managers. It gleans this information from the various filings that institutional investors are required by law to make. Portfolio Reports lists the buying patterns of such luminaries as Seth Klarman of Baupost, Lou Simpson of GEICO, Marty Whitman of Third Avenue, Peter Cundill of the Cundill Group, Bruce Sherman of Private Capital Management, and Warren Buffett. These managers aren’t 100 percent focused on distressed situations, but they are focused on value. Distressed situations are a subset of value investing, so some of their investments fall into the distressed category. 4. If you’d like to avoid the subscription price tag for Portfolio Reports, then much of that data can be gleaned by looking directly at the public filings (e.g., SEC Form 13-F) that institutional investors have to make. These can be accessed on the EDGAR system (http://access.edgar-online.com). Alternatively, www.nasdaq.com provides much of the data in condensed form.

Chapter 9 Dhandho 202: Invest in Businesses with Durable Moats

It is virtually a law of nature that no matter how well fortified and defended a castle is, no matter how wide or deep its moat is, no matter how many sharks or piranha are in that moat, eventually it is going to fall to the marauding invaders.

average Fortune 500 company had a life expectancy of just 40 to 50 years. It takes about 25 to 30 years from formation for a highly successful company to earn a spot on the Fortune 500. Geus found that it typically takes many blue chips less than 20 years after they get on the list to cease to exist. The average Fortune 500 business is already past its prime by the time it gets on the list.

Chapter 10 Dhandho 301: Few Bets, Big Bets, Infrequent Bets

There is a wonderful book written by William Poundstone entitled Fortune’s Formula that is well worth reading. Poundstone describes the Kelly Formula beautifully.

The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple. —Charlie Munger

To be a good capital allocator, you have to think probabilistically.

Dhandho is all about placing few bets, big bets, infrequent bets; and the Kelly Formula supports this hypothesis. This approach works exceedingly well in making passive investments in the stock market.

Chapter 11 Dhandho 302: Fixate on Arbitrage

We know that all Dhandho arbitrage spreads will eventually disappear. The critical question is: How long is the spread likely to last and how wide is the moat? As stated by Mr. Buffett:   The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. —Warren Buffett

Always look for arbitrage opportunities. They allow you to earn a high return on invested capital with virtually no risk. Exploit these Dhandho arbitrage spreads for all they are worth.

Chapter 13 Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses

It is a textbook example of a situation with ultra high uncertainty and ultra low risk. If presented with such a scenario, Wall Street will irrationally collapse the quoted value of the business. Always take advantage of a situation where Wall Street gets confused between risk and uncertainty. The results will usually be quite acceptable.

Chapter 14 Dhandho 403: Invest in the Copycats rather than the Innovators

investing in businesses that are simply good copycats and adopting innovations created elsewhere rules the world.

Good cloners are great businesses. Innovation is a crapshoot, but cloning is for sure.

Value investing is fundamentally contrarian in nature. The best opportunities lie in investing in businesses that have been hit hard by negativity.

Even the pundits of the efficient market theory, Eugene Fama and Ken French, concluded that stocks in the lowest decile of price/book ratios outperformed stocks in the highest decile by over 11 percent a year from 1963 to 1990. If you had invested $10,000 consistently in stocks with the highest price/book ratios (the Googles of the world) in 1963, it would have grown to about $72,000 by 1990. Not bad. However, if you had invested those same dollars in the cheapest businesses, you’d have $915,000 by 1990.

Chapter 15 Abhimanyu’s Dilemma—The Art of Selling

This is by no means a summary, but here are seven questions that an investor ought to be thinking about before entering any stock market chakravyuh:

1. Is it a business I understand very well—squarely within my circle of competence?
2. Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years?
3. Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 percent?
4. Would I be willing to invest a large part of my net worth into this business?
5. Is the downside minimal?
6. Does the business have a moat?
7. Is it run by able and honest managers?

A critical rule of chakravyuh traversal is that any stock that you buy cannot be sold at a loss within two to three years of buying it unless you can say with a high degree of certainty that current intrinsic value is less than the current price the market is offering.

Chapter 16 To Index or Not to Index—That Is the Question

Well-diversified indexes like the S&P 500 or the Russell 2000 are all but certain to outperform most active money managers over the long haul. It is a law of investing. As long as there are frictional costs, the vast majority of actively managed assets will underperform the broad indexes. This will always be true.

There have always been a small minority of investors and money managers who’ve successfully trounced the broad markets over long periods. These are, by and large, the Dhandho investors. It is worth studying the methods of these investors. If you want to be passive, it is very much worth the effort to find these managers and put your assets with them. A starting point is to consider investing with mutual fund families like Third Avenue, Longleaf, and Fairholme. All three are highly likely to do better than the broad indexes over the long haul.

Greenblatt came out with a very direct set of recommendations for the individual investor in The Little Book.5 Greenblatt has done the individual investor a huge favor by writing the book and setting up the free web site, www.magicformulainvesting.com. The book’s thesis is that buying good businesses when they are cheap is likely to generate vastly better returns than any broad index. Greenblatt’s Magic Formula works as follows: All U.S. publicly held stocks are sorted in descending order based on the return on invested capital they generate. If there are 3,000 stocks in this universe, some stock like Google might get a very low number (ranked near the top) and some stateowned steel company might be at the bottom of the list. He then generates another list, based on the price-to-earnings (P/E) ratio. The lowest P/E stock is ranked as 1, and the highest would be ranked as 3,000. Finally, he adds the two numbers for each stock. The businesses with the lowest resulting numbers show up as Magic Formula stocks. A company like Google might get a rank close to 1 for return on invested capital and close to 3,000 for P/E ratio, yielding a total number around 3001. It is thus unlikely to be a Magic Formula pick.

If an investor just analyzed stocks that are on the Magic Formula and have a VIC writeup, they are likely to do quite well.

Subscribe to Value Line (or review it at a library). Study their “bottom lists” every week. They list stocks that have lost the most value in the preceding 13 weeks, ones trading at the widest discounts to book value, lowest P/E, highest dividend yield, and so on. It is a wonderful treasure trove to dig in and discover.

4. Subscribe to Outstanding Investor Digest (OID; www.oid.com) and Value Investor Insight (www.valueinvestorinsight.com). Both carry detailed interviews and write-ups with some of the best value money managers in the United States. These are likely to deliver another idea or two for you to add to your funnel. 5. Subscribe to Portfolio Reports. It is published by the same people as OID, and it lists the recent buying activity of some of the best money managers in North America.

Another web site that is free and can partly replace Portfolio Reports is Guru Focus (www.gurufocus.com). This is a free web site that tracks the buying and selling activity of the leading value investors in North America.

Attend the biannual Value Investing Congress (www.valueinvestingcongress.com). It is held semiannually in New York City and Hollywood. It is well worth the price of admission. Not only do they teach you to become a better fisherman, but they also provide some fish at half price.